Australian interest rates May 2015

The May cut brought to a close ...

As we had forecast the Reserve Bank Board decided at its May board meeting to lower the cash rate by 25bps to 2.00%.

... a difficult forecasting period ...

For Westpac this brought to a close a challenging six months in forecasting. Readers will recall that on December 4 last year we changed our view, which had previously been that rates would be on hold over the next year, to expecting that the RBA would cut the cash rate in two 25bp tranches in the first half of 2015 beginning in February. When we made that change we were the only institution on record in the market surveys who forecast that the cash rate would be at 2% by May 2015.

... in which we took the lead.

The most surprising aspect of the Governor’s May statement is that he had not chosen to indicate a ‘soft’ easing bias. In fact, the explanation behind the decision indicates renewed optimism in the economy with the obvious implication that rates are likely to be on hold for some time. Specifically, he commented: “The Board judged that the inflation outlook provided the opportunity for monetary policy to be eased further, so as to reinforce recent encouraging trends in household demand”. [My emphasis].

The Bank’s $A concerns persist ...

Despite the lack of an easing bias, the language around the Australian dollar was among the most strident we have seen. Not only does the Governor predict that a further depreciation seems likely, he also labels it as “necessary”. It must have been a disappointment for the Governor to see that the Australian dollar lift to around US 79¢ (from 78.5¢) in the aftermath of the decision. This is clearly the market responding to the final paragraph which signals an end, at this stage, to the easing cycle, thus encouraging them to ‘look through’ the attempt at jawboning the exchange rate.

... but its policy bias points to ...

Those doubting that a cut would be delivered in May placed most emphasis on risks in the housing market. The Governor addresses that issue by pointing out that outside Sydney trends in the housing market have been varied. Once again he emphasised the macroprudential tools that the Australian Prudential Regulation Authority (APRA) is now enforcing within the banking system. It is our view that these guidelines will have a cooling impact on housing markets. For example industry data shows that banks have now increased their lending in the investor segment by 11.5% over the year. Banks are already setting out new tighter guidelines for lending in that space with the likely effect of dampening activity in the sector to some degree.

... 2% being the ‘resting place’.

In our previews to the meeting we emphasised that we expect that the Bank will lower its growth forecasts for 2015 and 2016 due to a weaker outlook for business investment, both mining and non-mining. The Governor clearly highlights business investment as the key drag on private demand. This decision has been confirmed in the revised forecasts which have been released in the May Statement on Monetary Policy. Forecast growth in 2015 has been revised down to 2.5% from 2.75% and growth in 2016 has been revised down from 3.5% to 3.25%. These forecasts are based on an assumption of “market pricing” for interest rates. Markets are currently assessing the probability of another cut of 25bps by year’s end as 60%. It probably suits the Bank to “frank” that assessment given its concern about the market’s response to the closing remark in the Governor’s post-meeting statement.

The Fed is a major factor.

For the first time in this cycle the Governor also chose to speculate on the policy of the Federal Reserve, with the expectation that the Fed will be tightening later this year. Clearly that will provide an important contribution to the Governor’s expectation that the Australian dollar will depreciate further. Westpac shares that view, with our current expectation that the Fed will begin tightening in September with a follow up move in December.

The evolution of the 2016 GDP forecast ...

We have consistently argued that 2% will be ‘the resting place’ for this easing cycle. The Bank will now take time to assess the sustainability of their current forecast that economic growth in 2016 will exceed 3%. The decision to lower the forecast in the current Statement on Monetary Policy is not an encouraging sign. That is still above trend growth and consistent with stability and an eventual fall in the unemployment rate. For our part the next significant date will be the November Board meeting. Market flirtation with a cut in the September quarter seems premature. By November the Bank will have sufficient information around the momentum in the economy through 2015 for it to assess whether its relatively positive outlook for growth in 2016 can be sustained.

... will determine the next policy phase.

Our current forecast is that despite an ongoing drag from mining and non-mining business investment there will be a sufficient momentum in household demand (both consumption and dwelling investment) to justify a 3% growth rate in 2016. However, with weak income growth, fragile confidence and ongoing headwinds from fiscal policy the risks to this outlook are to the downside. In addition, Australia’s ongoing yield advantage over other countries could frustrate the Bank’s ambitions to see a substantially lower currency. For the RBA, the Fed’s September meeting looms very large.

Bill Evans, Chief Economist

Reproduced from the May 2015 edition of Westpac's Market Insights

Past performance is not a reliable indicator of future performance. The forecasts given above are predictive in character. Whilst every effort has been taken to ensure that the assumptions on which the forecasts are based are reasonable, the forecasts may be affected by incorrect assumptions or by known or unknown risks and uncertainties. The results ultimately achieved may differ substantially from these forecasts.


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